Commodity Risk - Counterparty Concentration and Default Risks

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Life is full of pitfalls and risks. In another article, I gave an overview of the topic of risk in commodity markets. In that piece, I described the difference between assessed and non-assessed risks. That piece gave the view from 30,000 feet. This offering is a continuation of the series that examines risk on a granular basis. Two risks that are very important for those trading in the commodity markets are counterparty concentration and counterparty default risk.

Counterparty concentration occurs when a significant percentage of a portfolio has exposure to the same or highly correlated market counterparties. This increases the risk of losses caused by default events affecting these counterparties. This amounts to the same thing as the old saying, never keep all of your eggs in one basket. A great example of counterparty concentration would be a cocoa consumer that purchases all of their requirements from the world's largest producer of cocoa beans, the Ivory Coast. Many times consumers purchase on a forward basis. They agree on a price with a supplier for future delivery. Cocoa production tends to come from all over the world where there are equatorial climates, but this West African nation typically produces one-third of all supplies making it a dominant low cost market supplier. If a chocolate manufacturer were to concentrate all purchases from the Ivory Coast and for some reason the crop in a particular year was not good, or nonexistent, due to a weather event, crop disease or a political or logistical event, they would suffer from a concentration of their risk of supply from one source.

Therefore, consumers of commodities tend to spread their purchases amongst a number of different suppliers in different regions in order to mitigate counterparty concentration risk. This is just one example of this form of risk, however; the concept is applicable to a whole host of different raw material markets from a consumer's perspective.

On the other side, if a producer of a commodity were to sell to only one buyer they would have the same type of counterparty concentration risk. If the consumer went out of business or for some reason failed to perform on a contract the resulting losses would be due to this type of concentration risk.

Counterparty default risk is the risk that a counterparty fails to honor its financial or physical obligations under the terms of a contract due to inability to pay or perform. A perfect example of counterparty default is a situation that arose for me when I was running a physical nickel trading business in London in the late 1980s. I had contracted to buy physical nickel from the Russians. The deal involved a short-term pre-export finance. I paid the Russians, who were always short of cash in those days, up front for nickel they were contractually obligated to deliver three months in the future.

The deal occurred in late October for delivery in January. The Russian shipped the nickel from Siberia to Rotterdam by ocean vessel where I would take delivery of the metal. The problem arose that year because of an unusually cold winter in Siberia. It is usually cold in Siberia, but in this particular year, it was so cold that the ports in that region of the world froze making it impossible to ship the metal.

As word of the problem leaked out into the market, the price of nickel began to rise. I had hedged my purchase by selling forward contracts on the London Metal Exchange for January delivery. It turns out that the Russians had done the same deal with other nickel traders who all expected the delivery and sold to hedge price risk. We were all in the same frozen boat. The Russians could not deliver and we were not going to get the metal in time to deliver against our hedge positions on the LME. Many, including myself, had to buy back the hedges at a loss because our counterparty had defaulted on the trade.

This is just one example of a counterparty default and there are many other examples throughout history. In the world of commodities, a counterparty default arises when one party to a contract fails to deliver or the other party fails to pay as agreed.